With credit spreads easing, swap rates stabilising, and bond markets reopening, is European listed real estate finally rebound-ready? We have listed the 9 main reasons why we believe so:
1. Easing credit spreads
Since the end of 2022, we’ve seen a significant easing of credit spreads back to more reasonable levels, also compared to other sectors. Nonetheless, despite this marked improvement, the delta between credit spreads of real estate companies and of non-financial companies remains higher than historical averages. This suggests there is further room for an easing of those spreads.
2.Stabilising swap rates
The other component of the cost of debt, the swap rate, has observed a downward trajectory from its peak in 2023. Currently, swap rates are plateauing, indicative of the market's wait-and-see approach regarding potential central bank rate cuts. Thanks to the softening of both credit spreads and swap rates, the total cost of new financing has decreased from 6% in 2022 to about 4% now. This reduction significantly lowers the barrier for new projects and refinancing existing ones, enhancing the sector's investment appeal.
3. Reopening of the bond market
While the bond market for real estate was never fully closed, issuing bonds was prohibitively expensive for real estate companies compared to taking out loans—especially if the company had existing banking relationships and good quality assets. This situation on the bond market has taken a turn for the better, with a series of successful bond issues demonstrating a renewed confidence in the market. Thanks to the reopening of the bond market, fears have subdued that banks will need to shoulder the entire burden of refinancing maturing bonds.
4. Controlled rise in average cost of debt
The average cost of debt in the real estate sector is trending upwards; however, this increase is gradual and manageable, primarily thanks to strategic financial management involving long maturities, fixed interest rates, and comprehensive hedging strategies. These measures are key as they help stabilise repayment plans and protect against interest rate volatility. Importantly, the marginal cost of debt has gone down since mid-2023 and has remained stable so far in 2024. As a result, the average cost of debt is increasing at a slower pace than what was anticipated at the height of the inflation crisis.
5. Revival of the Positive Yield Gap
The gap between property yields and swap rates—the yield gap—has returned to positive territory. This means that the business model of borrowing money to invest in real estate is economically viable once more. The reopening of this gap will likely help to reopen the direct market for transactions. This should benefit price discovery and give more clarity about capital values, reducing the need for heavy discounts to net asset values (NAVs).
The gap between property yields and swap rates—the yield gap—has returned to positive territory.
6. Strong operating metrics
The sector is showing continued robustness in high occupancy rates and rental growth. The fact that real estate companies have been able to pass inflationary pressure onto higher rents shows their market power, thanks to favourable supply and demand dynamics. Indeed, vacancy rates in Europe are far healthier than those observed in Asia and the U.S., especially in the office and retail subsectors.
7. Decreasing leverage
During the years of quantitative easing, European real estate companies, especially those on the Continent, levered up a lot. This high leverage was a primary factor in the sharp rise in credit spreads. In the meantime, the management teams from real estate companies have recognised investor concerns regarding excessive leverage and have started to de-lever materially. This reduction in leverage levels should contribute to less volatility in share prices, creating a more stable investment environment. As loan-to-value ratios and net-debt-to-EBITDA ratios directly correlate with an entity's ability to manage and service its debt, a reduction of these leverage ratios reassures investors of the sector's long-term viability and resilience against economic fluctuations.
8. Attractive valuations
European real estate stocks trade at hefty discounts to their NAV. A discount is warranted when there is a lot of uncertainty about future operational and financial metrics. However, capital values are starting to bottom out in the UK, but also on the Continent. Credit spreads and swap rates have eased compared to their peak in 2022, granting more visibility on where the average cost of debt will end up. At the same time, rental growth and occupancy remain robust. Therefore, pessimistically discounted share prices are no longer warranted for European real estate in our view. We thus expect a reduction of the discount to a more historical average, which should drive up stock prices, all else equal. Such attractive valuations not only make European real estate a compelling investment opportunity relative to the past, but also relative to other global regions where stock market discounts are less pronounced.
Although the journey to normalised asset prices and share prices continues, the landscape is becoming increasingly favourable .
9. Increasing allocations
Once there is more certainty about the depth and speed of the policy rate cuts by central banks, we expect allocations to real estate to increase substantially. Given the historically low valuation of real estate stocks, a resurgence of interest from these investors should help drive up stock prices. A renewed interest from generalist investors would not only bring additional capital into the market but also enhance the liquidity and depth of the market. And this trend would be self-reinforcing, as the increased activity and positive sentiment can lead to broader market recognition and further investment inflows.
Although the journey to normalised asset prices and share prices continues, the landscape is becoming increasingly favourable.
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